As a business owner, it is safe to assume you would do anything for your business to succeed. However, how many of your team members would do the same? This key factor is why designing employee incentives such as a profit-sharing plan can help increase productivity while your staff remains loyal to your brand.
The main requirement for your company to thrive long-term is to empower your staff to treat it like it is theirs. Your wins become their wins and vice versa. Helping them establish ownership will make workers more accountable as their roles become better defined by their contributions.
This article will detail the benefits of establishing a profit-sharing plan, the different types of programs, how it differs from a 401K plan, and other options to consider.
Benefits of Profit-Sharing
A profit-sharing plan is an employer-sponsored contribution plan where the employer contributes pre-tax dollars to an employee’s account based on their business profitability. Companies of all different sizes can offer these plans, and this benefit is entirely up to the employer’s discretion.
As we slowly wade through the great resignation, one can surmise that when organizations share profits with their team members, this helps increase employee retention. Business owners can also attach a vesting schedule where a certain percentage is attained each year.
Besides employee retention, this added benefit also saves on taxes. If your company has had a successful year, implementing this plan will reward your employees without adding extra payroll taxes. As an added benefit, employees can also save on income taxes if they put this contribution towards their retirement, thus reducing their adjusted gross income.
Finally, studies show that productivity levels increase when your personnel can partake in the profit margins they are creating. When team members are directly impacted through their efforts and hard work rather than only being compensated for their time, they are more motivated to go that extra mile.
Types of Plans
There are four different types of profit-sharing plans you can use to reward your employees.
1. Deferred Profit Sharing Plan (DPSP)
With this plan, the employer shares the profits made from the business with all the employees enrolled. These funds are managed by a plan’s trustee, which can gain more considerable investments over time. This money may be withdrawn partly or entirely within the first two years of membership.
2. Cash Profit Sharing Plan (CPSP)
A cash profit plan involves paying a portion of profits directly to your employees that are taxed as regular income. Business owners may make disbursements in stock rather than cash, especially if you have a vesting program. CPSP can be a good incentive for younger employees who prefer having more money now versus retirement.
3. Employee Stock Ownership Plan (ESOP)
An ESOP enables employees to have ownership in the company either given to them or the opportunity for them to purchase. This plan type encourages team members to do what’s best for shareholders since the employees themselves own this stock.
4. 401K Plan
A 401K or retirement plan can be defined as a type of profit-sharing plan that has tax advantages to the saver. There are two basic types of 401Ks traditional and Roth. These differ primarily in how they’re taxed. Keep in mind, once money goes into a 401K, it is difficult to withdraw before retirement without paying taxes and penalties.
Regardless of the type of plan you choose; the profit-sharing percentage is typically between 10 to 20 percent of the total profit amount distributed. Create guidelines for how much and how often to pay that are appropriate for your firm. Make sure the specifics for each employee are documented in a profit-sharing agreement.
Profit-Sharing vs 401K
A 401K plan, named after the 401K tax code section that created it, is a tax-advantaged retirement account. Most of the time, this type of retirement plan involves a funding combination of both employer and employee.
The IRS limits the tax-deductible money one can invest in a 401K plan each year. Employees can contribute up to $19,500 to their 401K plan for 2021 and $20,500 for 2022. In addition, an employer may provide a matching plan, which can incentivize prospective candidates to accept a position.
Even though some organizations treat profit-sharing as part of a 401K package, it doesn’t have to be centered around retirement. Profit-sharing is often not tied to an employee’s retirement plan. Meaning an employee can withdraw this money as soon as they are fully vested.
Profit-sharing plans are flexible and allow employers to contribute when they choose, as long as there are substantial and recurring contributions. An employer is encouraged to contribute even if you have an underperforming year.
Options to Consider
There are specific criteria to establish when determining who is eligible for profit-sharing in your organization. Here are a few things to consider when creating your plan.
- Employee Eligibility – This type of plan requires a particular set of employee criteria to be met before being allowed to enter into a sharing fund. Examples are employment amount of time (1 year), US-based, over 18 or 21 years of age, or a union member.
- Contributions – A business will decide how much to contribute to a participants’ plan. Make sure to specify when this contribution happens, either at the end of the year or quarterly. Remember, you can deduct up to 25 percent of the compensation amount paid during the taxable year to all participants.
- Distribution – An employer can select the forms of distribution: lump-sum, periodic, annuities, or ad-hoc distributions. If you decide to create a vesting schedule, show how much is available after each period.
- Investing – When creating a plan, you will need to decide whether to allow your employees to direct the investment of their accounts or to manage the monies on their behalf. If you are selecting the investments, make sure to update actively to secure the value of your selections.
Regardless of good intentions, those operating the plan can still make mistakes. Fortunately, the U.S. Department of Labor and IRS have correction programs to help profit-sharing plan sponsors correct plan errors, protect participants’ interests, and keep the plan’s tax benefits. Establishing an ongoing review program makes it easier to spot and correct mistakes in plan operations.
Profit-sharing plans can serve as a powerful incentive for many organizations for employees and owners alike. Employers may find a profit-sharing plan invaluable in today’s economy by boosting morale and employee retention while providing a tax benefit to everyone.
FINSYNC can help you establish a profit-sharing plan that tracks contributions, investments, and distributions over time so you are ready for tax season and can experience financial harmony within your organization.